Over the past few years, one of signature funds at Blackstone, the private equity giant, has delivered, on average, 10 percent annual returns for its investors. The fund, which specializes in private credit, has lent money to more than 400 borrowers, who in turn have deployed those loans to become more profitable themselves.
And yet, in the first quarter of this year, nearly 8 percent of the fund’s investors declared they wanted out. Something similar has happened at funds managed by Apollo (where redemption requests hit 11.2 percent), Ares (11.6 percent) and Blue Owl (21.9 percent).
When asked on CNBC to explain why his investors are asking for their cash back, Blackstone president Jonathan Gray blamed “noise” — a “disjointed environment now between what’s happening on the ground with underlying portfolios and what’s happening in the news cycle.”
He may well be right. Another explanation might be that we are witnessing a kind of slow-motion bank run. Investors, spooked by a litany of bad news, are rushing to pull their money out of private credit funds. If they all ask at once, these funds — and potentially the firms that manage them — could falter.
To quote the great Taylor Swift: “I think I’ve seen this film before and I didn’t like the ending.”
In March 2008, also on CNBC, the Bear Stearns chief executive, Alan Schwartz, insisted that despite “speculations,” the firm’s balance sheet hadn’t weakened at all. It failed over the course of the next few days, ushering in the global financial crisis and years of economic stagnation. Then too, executives blamed unsubstantiated rumors for the firm’s collapse.
Private credit firms find the 2008 comparison infuriating. No one today believes any large financial firms are on the brink of collapse, nor that we are days from a systemwide meltdown. But it looks like the market is getting wobblier: Last October, I suggested that the failures of a few companies that borrowed from private credit funds were the first dominoes to fall and that more would follow. It appears that many private credit investors woke up to that risk — and now want to cash out.
Private credit funds operate in many ways like regular banks. If you’re a company, you can get a loan from either. Indeed, private credit funds have displaced banks as the largest originator of loans to firms that already have significant debt or low credit ratings (meaning, high risk for lenders).
Because they’re less heavily regulated, private credit funds can often offer companies better loan terms than banks. This regulatory arbitrage explains why private credit has grown so dramatically in the aftermath of the financial crisis, when banks pulled back from risky lending. This is a classic problem in regulation. A dynamic industry like finance will invariably exploit holes in the regulatory regime. Economist Alfred Kahn hoped “an ingenious regulator will never run out of fingers” to plug them.
Private credit executives are quick to say that although they lend like banks, they aren’t risky like banks, since they don’t take customer deposits. Depositors can run when they get squeamish and demand that banks liquidate long-term investments to return their cash. Bank deposits are also guaranteed up to a cap by the government, which means when a bank is teetering, both the financial system and taxpayer dollars are exposed.
Private credit players may have made bad bets — the software industry might be one, given the impact of artificial intelligence on the business — but, they say, the sector should be free of runs. Losses should be contained to the investors in these firms, end of story.
I suspect private credit doth protest too much. In a bank run, short-term depositors demand money that banks have used for illiquid long-term investments that are hard to value in real time. Semiliquid retail private credit funds expose investors to exactly the same risks. That means a private credit run may well be on the horizon, when, after a long period of economic growth, good returns and few bankruptcies, market conditions invariably sour.
Although it is technically accurate to say private credit firms do not take deposits, they raise capital from comparable activities. Many private credit firms buy insurance companies and use policyholders’ dollars to make long-term loans, much like banks use depositors’ dollars to do the same thing. Apollo pioneered this strategy with its acquisition of its insurance subsidiary Athene, and now upward of 40 percent of the dollars that the firm invests come from insurance policyholders. Many large private credit players operate this way.
Insurance dollars aren’t themselves exposed to run risk — Warren Buffett called insurance premiums a form of “permanent capital.” But this approach means that in a downturn, retail insurance policyholders will invariably be exposed.
History suggests the next credit crisis is looming. Financial cycles tend to last around 15 to 20 years, and it’s been nearly two decades since the last downturn. When that time comes, the absence of an explicit government guarantee will most likely not be sufficient to forestall the need for intervention. In the 2008 financial crisis, policymakers moved to bolster the insurer American International Group, not because its policies were guaranteed (they weren’t), but because losses risked further cascading damage through the financial system.
Also, as private credit has grown, it has started targeting retail investors directly, in addition to big institutional ones. Mostly, that’s been wealthy people, but the scope is broadening. Last week, the Trump administration proposed a rule that would make it easier for 401(k) plans to be invested in private credit, following up on an executive order from the summer that called for “democratizing access to alternative assets.”
As private credit has gone more retail, the investors that make up its base look more like bank depositors. And they’re acting in similar ways, too, skittish and prone to panic. Although private credit funds explicitly limit investors’ ability to cash out on demand, it seems like many didn’t read the fine print. It’s no surprise that in recent months, as the golden age of private credit looks a little less shiny, individuals are seeking to redeem more of their cash than private credit funds generally permit.
Much like the canonical bank run in the film “It’s a Wonderful Life,” where lovable banker George Bailey is left to apportion $2,000 among angry depositors, Apollo is asking people to hold on and take 45 cents on every dollar they want back. Other firms are relaxing their redemption caps to meet investor demands, betting that letting itchy investors get out could prevent others from bolting.
If investors run, private credit firms will be forced to liquidate their long-term investments, much like banks were forced to do the same in the financial crisis. The potential fire sales of loans made to thousands of companies would be debilitating to the system, because they decrease the value of the loans that others have made, too.
Worth keeping in mind, for those nervous about private credit runs, is that the market is a relatively small sliver of the financial sector. It’s a roughly $2 trillion market, compared to a banking industry more than 12 times that size. That means the aftershocks should be smaller than the bank failures of the past.
But we run real risks that the financial system is more interconnected than we appreciate. Banks themselves are wrapped up in private credit lending. Loans that banks are making to non-bank lenders, a group of firms that includes private credit, accelerated more quickly than any other type of bank lending in recent years. That means private credit risks could easily cascade throughout the system.
Although private credit firms do not tend to be highly levered, we don’t know much about the leverage their lending facilitates. The collapse last fall of First Brands, an automotive supplier, highlighted how private credit helps facilitate opaque debt structures that quickly generate losses for private and public lenders alike.
The Apollo chief executive, Marc Rowan, recently predicted that some of his peers will prove to have been good risk managers, and others less so. The question remains whether the industry — and the economy as a whole — will be able to shake it off.
Natasha Sarin, a contributing Opinion writer, is a professor of Law at Yale Law School. She is also the president and a founder of the Budget Lab at Yale and was a deputy assistant secretary for economic policy at the Treasury Department in the Biden administration and counselor to Treasury Secretary Janet Yellen.
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